Interest Rates continue to fall
Interest rates fell over the month of September and for the first time in New Zealand some market rates went negative. Into the tail end of the month government bonds with maturities out to 5 years were providing negative yields. This implies that a purchaser of these bonds, if they held them to maturity, would receive a negative return on their investment. The negative yields are a direct result of monetary policy in New Zealand and signal the expected direction and level of interest rates under the current policy settings. The RBNZ has advised financial institutions to prepare for the possibility of a negative Official Cash Rate (OCR) in terms of their systems. This is important as the OCR has an influence over the short- term interest rates retail investors receive from banks. The RBNZ has also continued to aggressively buy bonds issued to the market reducing the level of interest rates generally. Messaging from the RBNZ and Minister of Finance has been that interest rates will remain low, and potentially negative in some instances, for as long as required to lift the New Zealand economy back to full employment and a ‘healthy’ inflation rate. This suggests that the time period over which interest rates are at near zero levels will persist potentially for a number of years.
Term deposit rates have followed bond rates down. Bank term deposit rates are now below 2% on all terms out to 5 years. Despite the low current rates there is still some potential for interest rates to decline further given central government objectives and it is conceivable that term deposit and bond yields will follow.
The decline in interest rates has been prolonged and this has impacted on the income available from fixed interest investments. As interest rates continue to fall into 2021 clients who require a regular income from their investment portfolio, and have an allocation to fixed interest, will find the return from this asset class will be near zero. These low interest rates may continue over the next few years, requiring those investors to re-evaluate their objectives and expectations. Allocating more investments to shares can increase the income as well as the return for investors over the long-term, but this will come with additional risk of the capital value of their portfolio rising and falling.
Portfolio Impact of Low Interest Rates on Debt Securities
Interest rates approaching zero, and potentially below, will result in the potential for capital gain but this is not on an open-ended basis. If eventually the current trend reverses and rates begin to rise in the future, then there is potential for capital losses to be incurred and given the low level of rates the magnitude of losses is amplified. An investor is faced with an investment class that after tax may generate an income for investors of close to zero but if interest rates rise, which may be some years away, a potential capital loss. We expect that in 2021 the risk and reward equation of investing and receiving nothing with the potential for a capital loss will test many investors’ patience. As an example of what an investor could expect from fixed interest is the recent new issue by Mercury Energy of a 7-year bond at 1.56% p.a.
Portfolio Impact of Low Interest Rates on Shares
The fundamental driver of share values is cash flow generation into the future, discounted to obtain a present value. Lower interest rates decrease the discount rate and increase
the theoretical value of the shares. Likewise, the relative attractiveness of dividends to investors improves as interest rates fall and provides a further driver to capital growth in share values. In this scenario both growth companies and yield companies are beneficiaries of the underlying monetary conditions.
In the short-term the translation of these market drivers is not always evident as other factors influence the direction and magnitude of price changes in specific securities. In the last month the S&P/NZX Gross index fell 1.6%. In contrast the S&P/NZX All Real Estate Gross index rose by 2.6%. The broader market index weakened as the previous market leaders A2 Milk and Fisher & Paykel Healthcare share prices fell over the month 17.5% and 9.7% respectively. These two companies are growth businesses with no and minimal distribution yield respectively. With the knowledge that low interest rates may be something we will need to live with for some time, property emerged from a period of underperformance as yields from property companies once again became compelling with an income return to investors of approximately 5% p.a.
Global share markets also lost traction in local and New Zealand dollar terms. The US market as measured by the S&P 500 lost the most ground. High flying stocks such as Amazon slipped (-8.9%) and investment flowed to value companies e.g. building materials (Martin Marietta +9%) and traditional delivery company FedEX (+15%). Initial public offerings of technology companies continued to be well received e.g. Snowflake and Unit Software listing at large premiums to issue prices.
Conclusion
The current interest rate settings are confronting conservative investors with a stark choice. If investors place greater weight on capital preservation, then the status quo in terms of asset allocation continues but this will be at a cost of minimal income. In order to generate some income from portfolios investors will need to consider increasing the risk within fixed income assets or move from fixed interest to other ‘stable’ assets that generate reliable cash flows, such as selected forms of property and infrastructure companies. Investing in these assets is not without hazard and is always subject to the characteristics of quality and price. There is a popular saying ‘TINA’. (There Is No Alternative). It looks like we might be in a low interest environment for some years and the hunt for income will put pressure on assets that offer an investor an income.
Information and Disclaimer:
Source: JMI (previously JMIS), the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.